Foreign

Exchange
Risk
 Exchange risk is all
about
Financial Risk

Foreign exchange risk is the risk that a business’

financial performance or financial position will be
impacted by changes in the exchange rates
between currencies.
Introduction

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is
a financial risk that exists when a financial transaction is denominated in a currency other
than the domestic currency of the company.

The exchange risk arises when there is a risk of an unfavorable change in exchange
rate between the domestic currency and the denominated currency before the date when the
transaction is completed.

Foreign exchange risk is a major risk to consider for exporters/importers and businesses
that trade in international markets.
Understanding Foreign Exchange Risk

The risk occurs when a company engages in financial transactions or maintains financial
statements in a currency other than where it is headquartered. For example, a company
based in Canada that does business in China – i.e., receives financial transactions in
Chinese yuan – reports its financial statements in Canadian dollars, is exposed to foreign
exchange risk.

The financial transactions, which are received in Chinese yuan, must be converted to
Canadian dollars to be reported on the company’s financial statements. Changes in
the exchange rate between the Chinese yuan (foreign currency) and Canadian dollar
(domestic currency) would be the risk, hence the term foreign exchange risk.
Foreign exchange risk can be caused by appreciation/depreciation of the base currency,
appreciation/depreciation of the foreign currency, or a combination of the two.
Types of Risk
 Transaction risk

Transaction risk is the risk faced by a company when making financial transactions
between jurisdictions or for involving more than one currency.

The risk is the change in the exchange rate before transaction settlement.

Essentially, the time delay between transaction and settlement is the source of
transaction risk.

Transaction risk can be mitigated using forward contracts and options.

When firms negotiate contracts with set prices and delivery dates in the face of a volatile
foreign exchange market, with rates constantly fluctuating between initiating a transaction
and its settlement, or payment, those firms face the risk of significant loss.
Translation risk

Translation risk is the exchange rate risk resulting from converting financial results of
one currency to another currency.
Translation risk is incurred by companies who have business operations in multiple
countries and conduct transactions in different currencies.
If results are reported in different currencies it becomes difficult to compare results and
calculate results for the entire company.
For this reason, all the results in each country will be converted into a common currency
and reported in financial statements.
This common currency is usually the currency in the country where the corporate
headquarters is based.
When a company is exposed to translation risk, reported results may be higher or lower
compared to the actual result based on the changes in the exchange rate.

E.g. Company D’s parent company is Company A, which is located in the USA. Company
D is located in France and conduct trading in Euro. At year end, results of Company D is
consolidated with the results of Company A to prepare consolidated financial
statements; thus, the results of Company D are converted into US Dollar.
Difference between Transaction and
Translation Risk?
Transaction vs Translation Risk
Transaction risk is the exchange rate risk resulting from Translation risk is the exchange rate risk resulting from
the time lag between entering into a contract and settling converting financial results of one currency to another
it. currency.

Actual Change in the Outcome

There is an actual change in the future outcome in There is no actual change in the outcome in translation
transaction risk since the transaction is entered into at risk since the visible change in results is merely due to
one point of the time and settled in the future. the currency conversion.

Mitigation of Risk
Transaction risk can be mitigated by entering into a Translation risk cannot be mitigated
hedging agreement.
Summary – Transaction vs Translation
Risk
The difference between transaction and translation risk can be understood by realizing
the reasons for them to arise. When a contract is entered to in the present, which will be
settled at a future date, the resulting risk is a transaction risk.

The exchange rate risk resulting from converting financial results of one currency to
another currency is the translation risk.

A company’s foreign exchange transactions should be managed carefully so that they are
not subject to significant changes since high transaction and translation risks are signs of
volatility.
 Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s market value is
impacted by unavoidable exposure to exchange rate fluctuations, which can severely affect the
firm's market share with regard to its competitors, the firm's future cash flows, and ultimately the
firm's value..
Such a type of risk is usually created by macroeconomic conditions such as geopolitical
instability and/or government regulations.

For example, an Indian furniture company that sells locally will face economic risk from
furniture importers, especially if the Indian currency unexpectedly strengthens.
Another example of an economic risk is the possibility that macroeconomic conditions will
influence an investment in a foreign country.

Macroeconomic conditions include exchange rates, government regulations, and political

stability. When financing an investment or a project, a company's operating costs, debt
obligations, and the ability to predict economically unsustainable circumstances should be
thoroughly calculated in order to produce adequate revenues in covering those economic
risks
Measuring risk
If foreign-exchange markets are efficient—such that purchasing power parity, interest rate parity,
and the international Fisher effect hold true—a firm or investor needn't concern itself with foreign
exchange risk.

A deviation from one or more of the three international parity conditions generally needs to
occur for there to be a significant exposure to foreign-exchange risk.
Financial risk is most commonly measured in terms of the variance or standard deviation of a
quantity such as percentage returns or rates of change. In foreign exchange, a relevant factor
would be the rate of change of the foreign currency spot exchange rate.
A variance, or spread, in exchange rates indicates enhanced risk, whereas standard deviation
represents exchange-rate risk by the amount exchange rates deviate
Managing Risk-Transaction hedging
Translation hedging
Transaction hedging

Firms with exposure to foreign-exchange risk may use a number of hedging strategies to
reduce that risk. Transaction exposure can be reduced either with the use of money
markets, foreign exchange derivatives—such as forward contracts, options, futures
contracts, and swaps—or with operational techniques such as currency invoicing, leading
and lagging of receipts and payments, and exposure netting.[17] Each hedging strategy
comes with its own benefits that may make it more suitable than another, based on the
nature of the business and risks it may encounter.
Translation hedging

Translation exposure is largely dependent on the translation methods required by accounting

standards of the home country. For example, the United States Federal Accounting
Standards Board specifies when and where to use certain methods. Firms can manage
translation exposure by performing a balance sheet hedge, since translation exposure arises
from discrepancies between net assets and net liabilities solely from exchange rate
differences. Following this logic, a firm could acquire an appropriate amount of exposed
assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives
may also be used to hedge against translation exposure
Strategies other than financial hedging
Firms may adopt strategies other than financial hedging for managing their economic or
operating exposure, by carefully selecting production sites with a mind for lowering costs,
using a policy of flexible sourcing in its supply chain management, diversifying its export
market across a greater number of countries, or by implementing strong research and
development activities and differentiating its products in pursuit of less foreign-exchange risk
exposure.

By putting more effort into researching alternative methods for production and development,
it is possible that a firm may discover more ways to produce their outputs locally rather than
relying on export sources that would expose them to the foreign exchange risk. By paying
attention to currency fluctuations around the world, firms can advantageously relocate their
production to other countries.
Thank You